Thursday, June 25, 2015

Small-cap stocks to outperform large-cap in the coming years

The chart below is a pair trade of small-cap Russell 2000 ETF (IWM) against large-cap S&P 500 ETF (SPY) with volatility normalization*:



For small-cap ETF we can see a good combination of a local (9-month) momentum and long-term underperformance against SPY, which creates a potential for a mean-reverting dynamics. I suppose it is reasonable to expect this potential to be realized in the coming years.

* Pair charts with each side being volatility-normalized are supposed to show mean-reverting behaviour because a long-term trend would mean that one side of the pair is consistently better in terms of return/volatility, which goes against CAPM.

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